A friend of mine recently asked me about the different stages of startup financing — so I figured I’d write it down for you too!
There are certainly other sources of startup capital besides the ones listed below, but these five are the top ones; and they’re typically used roughly in the order I list them.
This is typically the very first investment of money used to for market research and developing product.
It can come from the founder’s personal savings (e.g. from a severance package from the founder’s prior job) or from acquaintances (aka a “Friends & Family” or “F&F” Round).
Seed capital can be received as a loan on in exchange for common stock.
Note: Credit cards/American Express are also used as a startup fund option around this time.
Since seed capital is sometimes limited, it is often necessary for an entrepreneur to tap into wealthy individuals outside their friends & family — this is often called an “Angel” investor.
You can receive money from an angel investor as a loan that is convertible to preferred stock (often it converts to the Series A round of stock below).
Friends & Family investors sometimes participate in this “Angel Round” of financing.
Venture capital (VC) funding is typically used by companies that are already distributing/selling their product or service, even though they may not be profitable yet.
If the company is not profitable, the venture capital financing is often used to offset the negative cash flow.
There can be multiple rounds of VC funding and each is typically given a letter of the alphabet (A followed by B followed by C, etc.)
The different VC rounds reflect different valuations (e.g. if the company is prospering, the Series B round will value company stock higher than Series A, and then Series C will have a higher stock price than Series B).
If a company is not prospering, it can still get subsequent Series-rounds of financing, but the valuation will be lower than the previous series: this is known as a “down round.”
These rounds may also include “strategic investors:” investors who participate in the round and also offer value such as marketing or technology assistance.
In the Series A, B, C, etc. rounds of financing, money is typically received in exchange for preferred stock (as opposed to the common stock that insiders/seed capital sources (and perhaps even angel investors) receive).
If you want to learn some tips on VC funding, check out my How To Raise Money From A VC: Insider Tips article.
Note: A line of credit from a bank is another startup fund option around this time as well.
At this point, companies may be eyeing the following types of opportunities that require additional funds:
To do so, they can tap into mezzanine financing or “bridge” financing.
Mezzanine financing is often used 6 to 12 months before an IPO and then the IPO’s proceeds are used by the company to pay back the mezannine financing investor.
Finally, companies can raise money through selling stock to the public in what’s called an Initial Public Offering…or IPO.
The IPO’s opening stock price is typically set with the help of investment bankers who commit to selling X number of the company’s shares at Y price, raising money for the company.
Once the stock is out, it is traded through a stock exchange (like NASDAQ or American Stock Exchange).
Companies can offer more of their stock through additional offerings.
I’m sitting in on a packed breakout session at the SxSW conference with Charlie O’Donnell of First Round Capital.
If you’re interested in creating technology-driven businesses, you should know about Charlie.
I like Charlie because he’s worked both sides of the fence (founder/CEO of businesses and venture capitalist); and he’s extremely well-networked .
His current employer First Round helps entrepreneurs with their early financing (before the big venture capitalists get involved).
Note: If you want to know more about the different stages of raising money, check out The 5 Major Stages of Startup Funding article I wrote.
Think of them as a “feeder fund” to the larger investors. If you can sell First Round on investing in you, you’re about 100X as likely to get larger funding from more venture capitalists.
Here are some tips he shared with entrepreneurs:
Ask For Advice (not money)
He says: “If you ask for advice (from venture capitalists), you get money…if you ask for money, you get advice.”
Vet Your Product/Product Management is Key
Most startups have a biz person and a techie…but it’s the translation in the middle that’s key (someone to focus on what the milestones are, priorities, etc. for the product).
Simple things like getting wireframes of your products nailed down before you start coding can be a huge time saver.
“The best ideas are the ones that nobody thought would work.”
Everyone is good at coming up with feature ideas…it’s a lot tougher to pick the ones to prioritize on.
So, be very clear about who is in charge of product management.
Things Take Longer And Cost More Than You Think
Building a company will take three times as long and cost twice as much; or take twice as long as cost three times as much.
Have 2-Week Plans (not 6-month plans)
Focus on Small/Short Milestones
This is tougher but will make you more efficient. Again, this is where someone with product management is key.
Hiring Is Harder Than You Think
On-boarding is harder and takes longer than you think. A programmer, for example, takes awhile to get to know your systems.
Venture capitalists, O’Donnell adds, don’t always help: “VCs look only at top-level employees…and never ask details about lower level hires.”
Find people who have failed in your space because they’ve learned the most — don’t just talk to people at a successful company like Twitter.
You Might Consider Selling Customers First, VCs Later
It’s way easier to ask a venture capitalist for money than it is to ask a customer…but you should focus on getting sales from customer to increase your leverage with VCs.
For example, Square Space in New York focused on generating sales (as opposed to raising money from VCs) and is now in a position of greater control with raising money from VCs.
PR is really hard to do…there are not that many people who do it well.
You may get a bunch of public relations on the launch day, but it will be much tougher to get PR a few months later (unless you have a new milestone) — again, having greater frequency of milestones is a theme here.
Building a Startup Is All About “Unfair Advantages”
A key leverage point with VCs is your “unfair advantages.”
Examples of unfair advantages:
For example, Gary Vaynerchuk can jump on his Wine Library video blog right now and get a developer hired immediately — that is a good “unfair advantage” he has over his competition.
3 Must-Haves To Attract A VC
Caution: Don’t Idealize Strategic Investments
Don’t assume that when a strategic investor puts money in you that you’ll get everything from that company that makes sense.
He points to his startup Indeed raising $1 Million from the New York Times and assuming that the newspaper would promote Indeed on its highly-trafficked Jobs Web pages (which it wouldn’t do).
Start The Wind-Down Process Early
When you’ve raised venture capital and your business isn’t working out, leave yourself enough time to sell your assets.
That’s because the “wind-down” period of a business goes very fast and selling your remaining assets takes time and energy.
I sat in on a venture capital panel at earlier this month at eBay’s DevCon at San Jose headquarters. Below are some highlights.
Here’s the panel:
Sergio Monsalve, Partner, Northwest Venture Partners
Rob Hayes, Partner, First Round Capital
Ravi Mohan, Managing Director, Shasta Ventures
Mark Gorenberg, Managing Director, Hummer Winblad
(The questions were asked by Moderator Charline Li, Founder of Altimeter Group)
Where do you see the new opportunities to invest your venture capital?
Mark: We see four trends:
Ravi: The word is commerce. Not just e-commerce. Where do people want to buy?
I believe the mobile device is the platform to bring that together.
The second thing is that everything that is happening in the offline world, is increasingly happening in the online world.
Rob: One of the themes we invest in is the Implicit Web. People don’t really care where they buy things from. If I can reach into ebay though an API, Amazon through an API, etc…where can I put all this data together to tap into all this?
E-commerce used to be about getting the best price. Now it’s more about getting the best experience.
That’s why we’re invested in BazaarVoice— Companies have to get used to people saying bad things about them online (even on their own Web site).
Sergio: There’s a trend of big companies working with small companies.
I think we’re in the third inning of e-commerce. It’s now that the incumbents (big companies like eBay) are starting to reach out with small companies to have symbiotic relationships.
We’re seeing a lot agencies investing with us.
How does an entrepreneur get venture capital funding
Rob: If it’s a really good idea in a really big market with a really good team (and can they pivot when things don’t go exactly according to plan).
Mark: I think you’d be surprised at how many of us fund things that really early. We funded Ace Metrix even though we’d never met them. They had really done their homework.
Ravi: There are a lot of great business ideas…as entrepreneurs you have to really look at the market size and how disruptive your idea is.
Sergio: The question of pivoting is important to underline. I see innovation…as continuous innovation throughout the life of a company. If you look at a company like RackSpace (now a $1.5 Bil. market cap) the defining moment was not when they started the company…it was in 2001 during the meltdown.
Look at Qumranet (a year before selling to Red Hat) they completely scratched their plan. The market wasn’t there…so they were able to pivot the company and then get sold a year later (for $107MM).
When’s a good time for an entrepreneur to look for venture capital funding?
Mark: With Arbor Software — we talked to them when they were really young…we worked together for six months and we funded the company six months later.
Ravi — Plastic Jungle (an online exchange for gift cards) — we met with them last summer and it was a complete offline business. We began looking at the vision and what this could be.
Gary Briggs (eBay’s ex CMO) was an advisor and we started to look at it together. The whole process took seven to eight months. During that time we helped expand the vision of the company and bring in additional team members.
What are some alternatives to venture capital funding?
Mark: Bootstrapping is natural. The lines between angel and venture firms has really blurred. Angels have seen 30% to 40% of their net worth go away. As a result, we (VCs) are seeing entrepreneurs earlier.
What do you think about exit scenarios (liquidity events) for startups these days?
Ravi: You need to build a business that is worth something. I’m thinking of a business that will reach $100MM and is growing 20% to 30% with EBIDTA of 20% to 30%…and then apply 10 to 30 cash flow multiple.
If there is no exit, then we may end up dividending the cash to management and investors. Or sell to private equity firms.
Rob: I believe that we’re going to see a lot of exits between $50MM and $100MM. So, if you’re going for the billion dollar company exit, you should be talking to venture capitalists.
An entrepreneur with a $50 million exit could be taking care of their great grandchildren.
Ravi: Rob and I are invested in a company called Outright, a free accounting service — everything that a small business doesn’t want to do. One of our target markets is ebay sellers.
Now we’re going to roll Outright out on ebay Selling Manager in August or September.
Would you invest in a company that has done a DPO (Direct Public Offering)?
Mark: We tend to shy away from that. We like clean paperwork…private stock only.
What’s the biggest mistakes entrepreneurs make?
Rob: Not taking enough money. Entrepreneurs get so tied up in the dilution math. It’s the most painful thing.
Mark: Entrepreneurs saying they have no competition. That’s indicative of not doing enough homework.
Ravi: It’s market size. Just being intellectually honest about the market size is important.
Sergio: There’s a balance between optimism and being intellectually honest that is needed.